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Investors in the Treasury bond market are betting that the Federal Reserve’s interest rate hikes will drive the US economy into recession, even as stocks rally and analysts suggest the odds of such an outcome are shrinking.

Short-term US government borrowing costs exceeded their long-term equivalents by the widest margin in three months on Wednesday, and the gap is fast approaching the 42-year record hit during the regional banking crisis in March.

This situation, known as an inverted yield curve — most commonly measured as the difference between two- and 10-year Treasury yields — has preceded every recession in the past five decades. 

On Wednesday the yields were 4.74 per cent for the two-year Treasury and 3.78 per cent for the 10-year.

“Bad things happen when the yield curve is inverted,” said Mike Cudzil, a portfolio manager at Pimco. “With very inverted yield curves, you tend to see a slowdown in credit creation. This is one reason why a shallow recession by the end of this year, or beginning of next year, is our base case scenario.”

The yield curve flipped in April last year, but that inversion has deepened as the Fed has rapidly raised interest rates. This suggests markets are increasingly convinced the US central bank will continue tightening, which in turn will bring down inflation and curtail economic growth.

Wednesday’s lows came as Fed chair Jay Powell delivered testimony to Congress in which he said the central bank still had more to do to rein in inflation, despite pausing rate increases at its meeting last week.

Higher interest rates make it more expensive for companies and individuals to borrow money, while an inverted curve can result in less lending by banks, all of which hurts the economy.

Jurrien Timmer, director of global macro at Fidelity Investments, said it would be “foolish to bet against a recession”, adding that “when the yield curve gets inverted to this degree for this long, a recession has basically always happened”.

Yet the dramatic increase in interest rates has not yet been accompanied by a significant slowdown in economic data. US employers have continued adding jobs, albeit at a slightly slower pace than in 2022 and 2021, while unemployment is low and expectations for economic output have been rising.

The Fed’s own estimates of where the economy will be by the end of the year have improved since the spring, suggesting the US may avoid a recession.

The US stock market, after a panic during the most aggressive phase of the Fed’s monetary tightening, is back in bull market territory. 

“Despite 500 basis points of tightening, we’re just chugging along,” said Eric Winograd, director of developed market economic research at AllianceBernstein. “That resilience is what I think the Fed is expecting to continue . . . [but] the Treasury market appears to have a different point of view on the subject.”

A yield curve inversion typically indicates a recession is likely to arrive at any time in the next six months to two years. But some analysts are not forecasting a recession within this period: Goldman Sachs earlier this month said it had reduced the chance of a recession happening in the next 12 months to 25 per cent.

Markets for riskier assets such as stocks and corporate credit have also reflected this optimism. The blue-chip S&P 500 share index is up about 14 per cent this year, though many analysts have attributed this rally to growth in stocks tied to the boom in artificial intelligence.

Meanwhile credit spreads — the premium investors demand to hold riskier corporate debt over risk-free Treasuries — have fallen on both junk-rated and investment-grade bonds in recent months.

“Perhaps the recession obsession is misplaced,” said Kristina Hooper, chief global market strategist at Invesco US. 

“We’re seeing a divergence in markets. And it’s not just equities, it’s other risk assets too . . . So this to me, is an environment in which risk assets are suggesting this time could be different,” she added. 

Analysts such as Hooper explain the paradox in part by arguing that corporations have previously enjoyed a long period of low rates in which they were able to refinance their debt and push out maturity dates — something that could ward off a wave of defaults in the near term.

That trend is roughly true for homeowners too, who in the US now mostly have fixed-rate mortgages.

The divergence may also be attributable to the muted impact, so far, of the yield curve inversion on big banks. Banks typically borrow at shorter-term rates and lend at longer-term rates.

In a normal environment, short-term yields are lower than long-term yields and the difference between the two is profitable for banks. When the yield curve is inverted, that relationship is also inverted.

However short-term costs have been slow to rise for big banks. Deposit rates at many large institutions remain near-zero even though the Fed’s overnight rate is above 5 per cent.

“For the larger banks, deposit rates have not kept up with rising money market rates or the rising fed funds rate or Treasury bill rates,” said Timmer. “That’s one reason why the transmission mechanism of an inversion in the yield curve to a recession has not really worked yet.”

But Timmer added that this does not tell the full story. “​​I don’t think this will prevent a recession, only delay it,” he said. “This is the recession everyone has predicted but refuses to show up so far.”

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